Economist, Telegraph Columnist, Broadcaster

For Eurozone recovery QE is not the answer

How is the Eurozone economy doing? Given that the 18 countries sharing the single currency comprise the UK’s biggest trading partner, accounting for around half our international commerce, this is a question of major economic and political importance.

Whether the Eurozone stages a meaningful recovery over the next 12 months, stagnates, or collapses amidst a fully-blown melt-down – which remains depressingly plausible in my view – will significantly influence the UK’s economic path, determining the backdrop against which the 2015 general election is fought.

As such, the combined performance of the Euro-18 will have far more bearing on the future path of interest rates here than any words passing the lips of Mark Carney. That’s worth keeping in mind, amidst a tsunami of comment on the Bank of England Governor’s latest cryptic utterances.

The Eurozone, for all the improved mood music, remains on the brink of recession. If the region’s economy does fail to recover, or goes into reverse, that lowers the chances of the Bank of England raising British borrowing costs. I’m not saying that’s right. I’ve argued for a long time that UK rates should rise straight away, as regular readers will know. The reality is, though, that a cautious Monetary Policy Committee (and its extremely cautious political masters) will be even more hesitant to curtail ultra-low 0.5pc rates any time soon if the economy of our major trading partner looks to be on the skids.

The Eurozone expanded a mere 0.2pc during the first quarter of 2014 and what growth we saw was very unevenly distributed, skewed away from the “peripheral” southern nations and towards the northern core. Combined national income and investment activity has yet to regain its pre-crisis level.

Unemployment, meanwhile, remains high – at around 12pc of the workforce. The average jobless rate among youths is a jaw-dropping 25pc. The Eurozone’s performance has been so bad for so long that skills are fading and millions of youngsters lost to the mainstream workforce, doing permanent damage to long-term growth. Such outcomes generate deep discontent and extremism, of course – as we saw in last month’s European elections.

With growth sluggish between January and March, there had been high hopes that the second quarter would mark a big improvement, with the Eurozone economy finally reaching “escape velocity”. Industrial output rose 0.8pc in April, up twice as much as expected. This was the strongest increase in five months and no less than 1.4pc higher than the same month in 2013. These punchy industrial output numbers combined with strong retail sales to boost second quarter Eurozone GDP growth forecasts to 0.4pc or more. The International Monetary Fund then issued a buoyant 1.5pc projection for the year as a whole, rising to 1.7pc growth in 2015.

Last week, though, as the World Cup rolled on, and amidst the (entirely justifiable and necessary) row over the appointment of Jean-Claude Juncker as President of the European Commission, hopes of a second quarter Eurozone recovery seemed, almost unnoticed, to fade.

Preliminary survey data suggested economic activity slowed to a six-month low, with the PMI index for private sector activity falling to 52.8 in June, against expectations and down from 53.5 the month before. While figures above 50 point to growth, these results still suggested the Eurozone economy is “losing momentum”, according to the survey authors. On top of that, the European Commission’s own consumer confidence index fell to -7.5 in June, down from -7.1 the month before. Again, this was unexpected, with economists having forecast a rise to -6.7 instead.

In early June, the European Central Bank introduced a raft of measures aimed at stimulating the Eurozone, including negative interest rates and cheap long-term loans to banks. In the real world, it appears that firms and households failed to be impressed, with broader confidence measures also falling. The EC’s overall economic sentiment indicator, for instance, dropped from 102.6 to 102 this month, once again confounding predictions of a rise.

It strikes me that a significant reason economic sentiment fell unexpectedly in the Eurozone this month relates to fears that fighting in Iraq will push up oil prices. Crude has risen around 10pc since the Sunni insurgency kicked-off – and at least part of Iraq’s 3.5m barrels of daily production could yet be under threat. Any escalation of the crisis in Ukraine could also drag on Eurozone growth, not least if we see more sanctions on Russia, now a major trading partner of both Germany and Italy. Geo-political risk is certainly on the march.

As the Eurozone economy slips, it becomes more and more likely, of course, that Germany’s anti-money-printing resolve will collapse and the ECB will revert to overt quantitative easing. I often hear that it said that the ECB has avoided the QE practiced with such abandon by its British and American counterparts. That’s not true. The Frankfurt-based institution’s balance sheet has more than doubled since the Lehman collapse. It’s just that Euro-QE has been sneakier, lost in technical operations in a bid to avoid provoking the ire of German public opinion.

Be in no doubt, thought full-on ECB money-printing could soon be with us, especially if the Eurocrats want to weaken their currency, in a bid to get the economy moving. After all, “the Eurozone recovery is still weak, uneven and vulnerable,” as ECB surpremo Mario Draghi told a Dutch newspaper last weekend. “That’s why disruptions in the global economy could quickly change the situation”, he continued, in an unspoken reference to unashamed Euro-QE.

Perhaps the most commonly cited concern about the Eurozone economy is rock-bottom inflation. The region’s CPI rose by just 0.5pc year-on-year in May, down from 0.7pc the month before. I agree, of course, that there’s a deflation risk. If deflation hold, Eurozone spending could fall off a cliff, with widespread household and corporate distress as real debt levels soared. Deflation also stymies the adjustments in relative real-terms wages and prices that are needed to stage a meaningful and sustainable economic recovery.

Which brings us to the heart of the matter. The Western political classes, the financial services lobby and almost every mainstream economist will tell you that this Eurozone deflation risk exists because the ECB has been “unimaginative” compared to other major central banks, resisting the urge to engage in massive monetary expansion. Ergo, if the Germans loosen up, and allow big-time Euro-QE, everything will be rosy.

Such an argument, while it serves the banks and investors that get rich on QE, and allows politicians to bury their problems, is wrong on so many levels. The Eurozone’s base money has grown like topsy, even if by not as much as in the UK and the States and in a way that’s been designed to confuse voters. And the reason there’s a deflation risk in the Eurozone isn’t because QE hasn’t been big enough, but because Europe’s zombie banking sector remains moribund and awash with bad debts, resulting in a lending contraction every single month since the start of 2012. That’s what lays behind the Eurozone’s economic torpor, not a lack of government spending and most certainly not a lack of QE.

Rather than insisting on painful debt write-downs, and forcing a necessary restructuring of the banks, the ECB looks set to follow its misguided Anglo-Saxon counterparts by hosing down its banking sector with yet more virtually printed money instead – and just in time for the upcoming autumn stress tests. That will boost asset markets, of course, but inevitably lead to further economic stagnation. Why? Because rather than fighting deflation, QE actually causes it.